We tend to
undervalue the future. Nowhere is this tendency stronger than in
finance, and nowhere in finance is it stronger than in the mortgage
market. Borrowers focus on the monthly payment, because that is today’s
problem, to the neglect of how much they owe and the future obligations
they may face, because those are tomorrow’s problems. I have termed this
“payment myopia.”
The System Encourages Payment Myopia.
Like all sales
people, loan officers and mortgage brokers sell an alluring present, not
a challenging future. Lenders have created instruments that support
their efforts by offering reduced payments in the early years at the
cost of higher payments and larger balances in later years. The most
radical of these was the so-called option ARM, which allowed borrowers
to make payments that did not cover the interest for 5, and in some
cases 10 years before the hammer fell. Since the crisis erupted in 2007,
the default rate on option ARMs has been so horrendous that they are no
longer being written. But payment myopia continues.
Today, the
instrument that most appeals to the payment myopic is the interest-only
(IO) mortgage. On IOs, the borrower pays only interest in the early
years, usually for 10 years. All adjustable rate mortgages have an IO
version, as does the 30-year fixed-rate mortgage. There are some
defensible reasons for selecting an IO, which I discuss in
Mortgage Selection in the Post-Crisis Market, but most borrowers who
take them do it for the lower payment in the early years, to the neglect
of the future. That’s why I don’t like IOs.
Ways to Overcome Neglect of the Future
Recently I have
begun to think about possible ways to overcome payment myopia, other
than preaching, which I know from personal experience doesn’t work. I
was provoked by a recent discovery of a method of inducing more
employees to sign up for retirement plans offered by their employers.
That a large proportion did not take advantage of plans that were highly
advantageous to them was another manifestation of the general tendency
to undervalue the future. Underfunding retirement plans and payment
myopia have the same roots in the human psyche.
It was discovered
that if new employees, instead of being offered an opportunity to join
the retirement plan, were automatically entered and given an opportunity
to opt out, the participation rate increased dramatically.
Is there a comparable technique,
I wondered, that might induce mortgage borrowers to give greater weight
to the future in their mortgage decisions?
Confronting Future Costs
Part of the reason
why borrowers discount the future so heavily in making mortgage
decisions is that the future is not as clearly seen as it could be. As a
general rule, the right type of mortgage for John Doe is the one with
the lowest total cost for Doe. The total cost is a borrower specific
number, because it depends on how long the borrower expects to have the
mortgage, his investment rate and his tax rate. Total cost is the sum of
all monthly payments of principal and interest, points and other
settlement costs paid upfront, lost interest on monthly and upfront
payments, less tax savings and balance reduction.
But Doe does not
know the total cost of the various mortgages he is offered because
nobody calculates it for him. He knows the starting mortgage payment
very well because it is shown on multiple documents. Hence, what should
be a limiting condition – the starting payment must be affordable – for
all too many borrowers becomes the only thing they look at in making a
selection.
Here is an
illustration using an IO, which as I noted above has a strong appeal to
payment myopic borrowers. On February 10, a prime borrower could have
had a $300,000 30-year FRM at 4.875%, or an IO version of the same loan
at 5.5%. The payment on the first was $1587, and on the IO it was $1375,
a difference of $212 a month. Over 10 years, that amounts to a saving of
$25,516. In addition, assuming the borrower can earn 2% on his money and
is in the 27% tax bracket, the interest loss on payments is $1939
smaller on the IO, and the tax savings at 27% is $9020 higher. This adds
to a total of $36,475 in “saving” on the IO. But, at the end of 10
years, the borrower will still owe $300,000 on the IO, and only $243,101
on its fully amortizing counterpart, which is a balance reduction of
$56,899. Bottom line, the total cost is $20,424 larger on the IO.
Oh, yes, let’s not
forget that in month 121, the payment on the IO jumps from $1375 to
$2064, where it remains for the next 20 years. The fruits of payment
myopia are indeed bitter.
So how does a
borrower who is determined not to be payment myopic find the total cost
of different mortgages? Don’t expect to get it from your loan provider.
If you have all the necessary details about the alternative mortgages,
you can calculate the total cost to you of each mortgage using my
calculator 9ai. The only on-line source that will calculate the total
cost for you automatically is
www.home-account.com, in which I have a financial interest. Their
commitment to provide the borrower-specific total cost of every loan was
part of my deal with them.